Monday, 29 March 2010

US Treasury yields rise

James Hamilton has noticed the recent rise in the yield of US Treasuries and asked: How scary is it?

A Wall Street Journal report on Friday had suggested that the rise in yields on the back of weak demand for three big US Treasury offerings last week was a cause for concern.

A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher -- a climb that would jack up the government's borrowing costs and spell trouble for the fragile housing market.

In his blog post yesterday, Hamilton noted that not everyone was concerned.

Paul Krugman (also here) and Brad DeLong are not concerned, noting we've seen lots of yield changes of this size or higher in the past.

Nevertheless, Hamilton acknowledged that the concern is not completely misplaced.

Even so, whether demand will continue to be there for burgeoning U.S. debt is obviously a question of great interest. Yields are now near the highest levels we've seen since the Lehman failure in September 2008, and if they continue to move up at their recent pace I wouldn't want to dismiss it as an irrelevant development.

Hamilton ruled out inflation as the driver of the recent rise in yields.

One possibility that I think we can rule out is that recent bond moves signal renewed worries about inflation. The recent surge in yields on Treasury Inflation Protected Securities is just as dramatic.

Hamilton also noted that stock prices have been going up along with bond yields.

When bond yields and stock prices rise together, I would usually read that as a signal of rising investor optimism about future real economic activity. The February numbers for home sales and other indicators that we've been receiving most recently don't exactly support that thesis. Let's hope that investors are correctly anticipating that better news lies ahead.

One could argue though that by at least one measure of economic activity -- the Chicago Fed National Activity Index -- bond yields have actually not kept up with the improvement in the economy.

However, the recent rise in yields may not mark the end. Today, Bloomberg reported that forecasters expect further increases by the end of the year.

Yields on 10-year notes, the benchmark for everything from mortgages to corporate bonds, climbed as high as 3.92 percent last week from a low of 3.53 percent in February. The 18 primary dealers of U.S. debt forecast the rate will reach 4.2 percent this year, the highest since October 2008, according to the median estimate in a survey by Bloomberg News.

Incidentally, the Bloomberg survey also saw a median year-end forecast for the federal funds rate of 0.5 percent. This implies a spread between the 10-year Treasury yield and the federal funds rate of 3.7 percentage points, an extraordinarily high, although not unprecedented, level.

The spread, if it materialises, could imply that the US economy would be operating under an extraordinary degree of stimulus more than a year after the recession ended, except insofar as the spread represents an aversion to US government debt.

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